What it means
Value is not a single fixed number. A valuer must first decide what kind of value is being measured, and the standard of value is the answer to that question.
It sets the rules for who the hypothetical buyer and seller are, what they know and whether special benefits to a particular buyer count. The most common standard is fair market value, the price at which a willing buyer and willing seller, both informed and under no pressure, would agree to exchange an asset.
Fair value, used in financial reporting and in some court cases, has its own definitions that vary by context. Investment value reflects the benefits to a specific investor, such as savings from combining two businesses.
Different purposes call for different standards. Tax matters, such as gifts and estates, usually rely on fair market value, while disputes among shareholders may use fair value as defined by law.
Deal negotiations often involve investment value, because each buyer sees different synergies. The standard drives practical choices in the valuation.
It affects whether discounts for lack of control or lack of marketability are applied, whether buyer-specific synergies are included and what date the value applies to. Two competent valuers using different standards can produce different answers without either being wrong.
For managers, the key point is to agree the standard before commissioning a valuation. Write it in the engagement letter, together with the valuation date and the purpose, so everyone understands what the number represents.
A figure used for the wrong purpose can create disputes with tax authorities, courts or partners. A related idea is the premise of value, which describes how the asset is assumed to be used, such as as a going concern or in liquidation.
The standard and the premise work together to define the question being asked. Always state both.
In practice
Real-world examples.
Example
A family owns a manufacturing company and plans to gift shares to the next generation. The tax adviser commissions a valuation on a fair market value basis, which includes a discount because the shares are a minority stake. The result sets the value reported for gift tax.
Example
A large retailer considers buying a smaller rival and estimates that combining distribution networks would save $3 million a year. The retailer calculates investment value, which includes those savings. This gives a higher figure than fair market value and sets the most it should pay.
Example
Two shareholders fall out and one asks a court to value the company for a buyout. The court applies the standard of fair value defined by the relevant law, which excludes minority discounts. The valuation expert prepares her report to match that definition. She sets out each assumption in an appendix so the court can see exactly how the figure was reached. The report names the standard applied and the reasons for choosing it, which lets a reader years later see the basis.
Case study
Seen in the real world.
Larkspur Engineering is a fictional company owned by three partners, one of whom wants to exit. This illustrative scenario shows how a standard of value can change the outcome, and it is not a real dispute. The partners hired a valuer without specifying the standard.
The valuer used fair market value and applied a discount for the lack of control and marketability of the leaving partner's stake. The leaving partner argued that the price should reflect the full value of the business with no discount, because the company's articles called for a fair value buyout. After legal advice, the partners agreed to commission a new report on the fair value basis, and the price rose by about 25%. They now include the required standard in every valuation engagement letter, and the company's accountant keeps the reports together with the shareholders' agreement.
Watch out
Common mistakes.
- Asking for a valuation without saying what standard to use. Without a clear standard, the valuer must guess the purpose, and the result may not fit it.
- Treating fair market value and fair value as identical. The terms differ in law and accounting, especially around discounts.
- Using a value prepared for one purpose in a different setting. A tax valuation may not suit a negotiation or a dispute.
Questions
People also ask.
What are the common standards of value?
The main ones are fair market value, fair value and investment value, with others such as intrinsic value used in some contexts.
Who decides the standard of value?
It is set by the law, contract or purpose of the valuation, and then written into the valuer's engagement terms.
Does the standard affect the final number?
Yes, it determines which discounts, premiums and buyer-specific benefits are included, so it can change the result materially.
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